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Thursday, March 26, 2009

The Latvian Cat Is Out Of The Bag

Reuters this morning:

The International Monetary Fund (IMF) would back a devaluation in Latvia, but the government, central bank and European Commission are against, the prime minister was quoted on Thursday as saying. It was the first clear statement by a policy maker about a differing stance between the IMF and Latvia and its other lenders over the currency, though the Fund has warned that keeping the currency peg during a sharp downturn would be tough. "The International Monetary Fund has no objection to a devaluation of the lat, but the European Commission, Bank of Latvia (central bank) and the government do not support this solution," Baltic news agency BNS quoted Prime Minister Valdis Dombrovskis as telling a meeting of regional journalists.

and Nordea flash comment:

According to Latvian Prime Minister Valdis Dombrovskis the IMF has no objection to a devaluation of LVL. However, he continues that the European commission, Bank of Latvia and the government are against devaluation. IMF's opinion counts as Latvia is asking the fund for a permission to increase the budget deficit to 7% of the GDP from the agreed 5%. Latvian economic contraction has been worse than expected. Getting out of the woods requires that competitiveness must be improved. This can be done by external or internal devaluation. IMF's stance highlights the risk of external devaluation. However, it is not a done deal since the political opposition is very hard. Some 90% of the Latvian loans are in foreign currency and hence external devaluation would affect most Latvian households and companies. Ongoing discussion emphasizes the importance of hedging the Baltic FX risk. If Latvia gives up, speculation that the other Baltic countries follow, increases.

A change in the peg is strongly opposed by the Latvian authorities and by the EU institutions, and thus would undermine program ownership. The quasicurrency board has been an anchor of macroeconomic stability for more than 15 years, was able to withstand the 1998 Russian crisis, and commands popular and political support. Any change in regime would cause significant economic, social and political disruption.

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

So the only real news that Valdis Dombrovskis seems to be announcing today is that the central bank the Latvian government, the EU Commission, the ECB (and possibly) the Nordic Banks are the explicit villains of the piece.

Personally I am very sorry that we are now coming to what may turn out to be a "disordely" resolution of the four East European pegs, since I think it didn't have to be like this, as I have argued in:

we can see that it is the political crisis which ultimately breaks the loop. Without the devaluation Latvia is stuck in a self reinforcing contraction where budget cuts slow the economy further and make necessary further cuts, while all the time more and more toxic assets are created, faster than you can borrow the money to clean them up (you know, the ball of negative energy that feeds on itself).

Update Dombrovskis "Corrects" Himself

According to the latest out of Reuters Riga Latvian Prime Minister Valdis Dombrovskis clarified later this morning (Thursday) that the International Monetary Fund was not currently seeking a devaluation of the lat currency. Speaking to reporters at the talks he is holding with IMF representatives, Dombrovskis said his earlier words were a "historical review" of negotiations last year with the IMF. "The current agreement of an unchanged exchange rate remains in force," he told reporters. Of course, no one doubted it. But still........

9 comments:

Anonymous
said...

*The Latvian Cat Is Out Of The Bag*

The origin might come from the time when sailors were whipped because of insubordinate behavior. For this purpose the whip which was called because of her nine straps also "nine straps cat".The cat was taken out by the disciplinarian from a ledernen bag. Only at that time the captain of the ship announced the number of lashes to be given he took out the cat.

it is even more out of the bag now given imf's move on the latest tranche. also check out march reserve data just out (down 1.1bn$). non-residents seem to be fleeing latvia. i dont think they have more than a month or two to solve this, because the residents will join the exodus too and then it's all over.

I pretty much agree with the drift of what you say. I am watching this, and the pressure really is now on, especially since as the contraction continues budget pressures only mount.

But I am being a little careful, since I am presenting a general economic argument, which is now more or less clear and on the table, and I don't want to be accused of participating in promoting a run on the currency.

Thanks for this. They seem to be asking them to carry out an "exercise" under various scenarios. Obviously they are not looking for 40% across the board cuts, but since some areas will need to be "protected" this means the cuts will be deeper in others. They need all this on the table I suppose in order to be able to take some decisions.

The shocking magnitude of the necessary budget cuts is beginning to sink into the minds of ordinary people. Ministers and politicians, on the other hand, make comments like they "can't imagine being part of this process". It's pretty scary to contemplate what's going to happen as we don't get the next monies from the donors. Those 40% we were too late to make would seem like a good deal come beginning of autumn. I'd be on my way to the USA if it wasn't for my studies now. How am I going to lectures in the winter when half the professors are gone and there's no heating in the auditorium?!

Latin America

Demography

What is Latvia Economy Watch?

Latvia Economy Watch is a weblog dedicated to following the day to day progress of the Latvian economy. The Weblog arose out of my curiosity about the roots of the particular mix of economic problems which Latvia is facing, and about what might be learnt from studying these as they evolve.

Latvia has a historically unprecedented combination of structural problems stemming from an extraordinarily high inward flow of funds (producing excessive consumer demand) accompanied by an equally high outflow of labour (creating insufficient labour supply). The impact of the migration outflow is further aggravated by the low number of young labour market entrants which can be anticipated over the coming years following the collapse in fertility and live births post 1990.

The issue is further complicated by the fact that the Latvian economy needs to experience very rapid "catch up" growth if she is to become rich before she becomes old, and thus achieve a standard of living which will make supporting the increasing number of elderly dependents both viable and sustainable.

Needless to say none of these problems were ever really contemplated in the economic text books. Dealing with this whole problem set - and it is one which in one way or another is typical of what we may expect to see across Eastern Europe as a whole - has become a most pressing concern, both theoretically and practically.

A great deal more background and information about the theoretical perspective which informs this blog may be found over at the Demography Matters blog.

About

Edward 'the bonobo' is a Catalan economist of British extraction based in Barcelona. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

He is currently working on a book with the provisional working title "Population, the Ultimate Non-renewable Resource".

Apart from his participation in A Fistful of Euros, Edward also writes regularly for the demography blog Demography Matters. He also contributes to the Indian Economy blog . His personal weblog is Bonobo Land . Edward's website can be found at EdwardHugh.net.